old-line club, blaclc-balled. No one will trade with the miscreant, effectively putting the firm out of the maricet. If they do this in a number of his major stocks, hes out of business. Artificially high spreads enforced by intimidation of rival dealers have been a way of life, some critics of Nasdaq contended, during its more dian 25 years of existence.

Apparently its not only contention. In June of 1997, one of the largest Nasdaq firms, Herzog, Heine & Gedult, setded a class-action suit brought on by a Department of Justice investigation, that will pay back investors $30.8 million. The firm makes a market in 5,000 over-the-counter stocks. The suit charged that 35 brokerage firms colluded to keep trading spreads high on securities traded on Nasdaq h)etween May 1989 and May 1994. The settlement amounted to 25% of the firms capital. Two other large Nasdaq traders settled suits for multimillion-dollar sums earlier. At year-end 1997, two dozen Nasdaq dealers, including many of the nations largest brokerage houses, were close to settling a $900 million class-action suit for these practices.

In the late summer and early fall of 1996, the SEC, after some years of study, came to an agreement widi a reluctant Nasdaq on a number of trading reforms. The agency found that Nasdaq had failed to enforce compliance with the Exchange Act, "without justification or excuse." The most important reform was to try and limit the power of die club by forcing a number of trading changes, such as requiring a dealer to post an investors bid or ask on the system if it is t)etween the spread. The system began on an experimental basis for a limited number of stocks in early 1997. Nasdaq also agreed to spend $100 million in die next five years to enhance its system of market surveillance, which according to many critics was virtually nonexistent to then.

Naturally the club was not happy at die prospects of a curtailment of profits. At the time of the agreement some knowledgeable sources estimated profits would be slashed by one-third. Said Benjamin F. Edwards, the chairman of A. G. Edwards, a major regional broker, commonly regarded as old-line in protecting clients interests, "I diink die SEC has been blind to the economic facts of life."

What does diis all mean to you? It is still too early to state with any assurance how much protection you have gained. Some of the most rigorous proposals to curb the spreads were not adopted by the SEC. While the jury is still out, to me it seems that many of the costly old practices will continue with only minimal restraints. This means that it is still up to you as an investor to protect yourself against excessive spreads.

How? To begin with, dont be mesmerized by low commission rates. The commission may be only a small part of the cost of buying or selling a stock.

Let me explain. For a stock trading on Nasdaq, the commission may be under a penny a share at the cheapest discount firms. However, the broker is usually paid an additional fee of several cents per share to direct the business to a particular over-the-counter house. Thats right, the broker can get as much as double the fee that it charges in cominission to you for directing the business.

Why is the Nasdaq house willing to pay for the right to exercise your order? You guessed it, to eam the spread. If the spread is, say, $8 to $8 , the Nasdaq dealer will make 50 cents per share on the deal, and can easily afford to pay for your broker to direct the order to him. A discount broker, who charges very low commissions, or any other for that matter, would be sorely tempted to send your order to a dealer who will take a fat spread. What you gain on the commission you may lose many times on the spread. So dont rash to brokers who offer you a penny a share commission on Nasdaq trades.

Trae, the same thing often happens on the Amex and even the NYSE to folks who put in a market order to save a few pennies on commissions. But because Nasdaq does trade by far the largest number of small companies, the excesses are much greater in this market. Since market orders on any but the most liquid stocks can cost 25 cents or more in the bid-ask spread, transaction costs can again be many times the commission savings. For the few extra dollars it costs to put in a litnit order, you can save many times that on the spread.

I cant say it too often: Watch those spreads. There is no free lunch, especially on Wall Street. If you are getting super low commissions, its highly unlikely you are also receiving the same attention to execution. This then brings us to a rale:

RULE 39

When making a trade in small, illiquid stocks, consider not only commissions, but also the bid/ask spread to see how large your total cost will be.

It often pays to deal witii a market-maker directiy (many of the large national brokerage houses are market-makers on hundreds of over-the-counter stocks). You will probably get as good or a better execution this way, witiiout paying any cominission. (You dont pay commission if the dealer buys or sells to you in a principal transaction.) Finally, use a limit order-give tiie broker a fixed price to buy or sell at-and change it when necessary.

Table 15-3

Small Cap Value Funds As of 11/28/97

Source: Prepared from listings in The Wall Street Journal

In summary, there can certainly be a performance advantage for you in buying pint-sized contrarian stocks. But this advantage can easily be negated by the spread. In fact if you trade frequently, you can very easily come out behind, even though you have been right on every pick. Paying 10%, 20%, or more every time you buy or sell takes a big chunk out of your capital. As we saw, die academic studies that noted the huge retums from small-sized companies never considered this issue.

Should you abandon the small-cap market entirely? No, but if you go into it, avoid companies where the dealers have large trading spreads. Remember, most are trading for their own accounts, a virtually automatic conflict of interest. Second, and this also applies to larger stocks that are illiquid-use limit orders. A third good choice for the investor who wants to capture the higher retums theoretically available in small-sized stocks is to buy a small-cap value mutual fund. Table 15-3 lists several that I would consider.

Next well tum to market indices, another example of an investor pitfall where seeing is not believing.

The Index Trap

Most professional investors and increasingly large numbers of individuals compare how they do against an index. While this is a good benchmark most of the time, there are problems that you should be aware of. Take the granddaddy and most widely followed index of them all, the Dow Jones Industrial Average.

Far from being an accurate proxy for the stock market as a whole, the Dow index-and most other indexes-are just lists of bellwether stocks selected by a committee. The Dow Jones is made up of 30 stocks using